A BASIC GUIDE TO FAUJI FINANCE
Lt Col Arun Sharma doesn’t know whether to be happy or unhappy right now. He’d got his posting orders a few days back for taking over Command of a Battalion but in a remote, non-family station in J&K. He had taken a lot of pains to learn the basics of personal finance, got hold of a good financial planner who guided him well and aligned his financial investments in line with Arun’s future requirements painstakingly. But this posting at this juncture were threatening to undo his efforts of past one year. He was worried that his finances, not yet fully sorted out, will again slip back into anarchy!
He then hit upon an idea – why can’t his wife learn it and handle this since he couldn’t?
Sheela was appalled at the idea, to say the least! She said, “Arun, Why are you joking? Arun could make out that she’s not in a mood for serious discussions on this subject. What he said then shocked her, “Sheela. I’m going to a CI Ops area to command a battalion. What if I don’t come back from there? Will you still refuse to have anything to do with the money then?”
The education started the next day onwards. He gave out three basic principles that Sheela needed to be familiar with to know how to manage the money well. This is how the narrative went:-
“The very first thing that you need to know is something called Inflation. Simply put, it just refers to the percentage rate at which our everyday things become costly year after year. India’s long term inflation rate is typically in the 7.5% compounded per annum range. This implies that if something costs Rs 100 today, a year later it is likely to cost Rs 107.50 and a further year later, Rs 115.60, and so on….
But how does this knowledge affect our own money?
Let’s say our money is lying in a savings bank account where the interest rate is 4% per annum today. Our Rs 100, if kept in a savings bank account for one year, will only grow up to Rs 104. Thus what this Rs 100 could buy this year, it will not be able to buy next year because the item would then be costing Rs 107.50 due to inflation while our own Rs 100 will grow to only Rs 104!
And imagine what would be the state if the amount involved was Rs 1 Lakh, 10 Lakhs, 20 Lakhs or even more? Hence, inflation is a very live concept which affects our everyday living. You have to ensure that overall your money should earn more than what inflation can take away.”
That is the first lesson that we must keep in mind.
Arun continued. “Sheela, you would have heard about taxation by way of Income Tax entry that appears in my pay slip every month. Income Tax obviously reduces the net money that becomes available to us for our use. You’ve also heard people, including me, grumbling all the time that they’re paying too much of tax on their salary and investments.”
So, how does it show up?
“Say we put some of our money in a bank FD which pays us 8% interest annually - this is definitely above the inflation rate of 7.5%. We may feel that our money is earning above inflation and hence we are safe. But remember, I’m in the 30% tax slab”.
He explained that everybody’s earnings are taxed by the Govt as per laid down tax slabs. Currently they are:-
0% tax for up to 2.5 Lakhs yearly earnings; 10% tax for 2.5+ to 5 Lakhs earnings; 20% for 5+ to 10 Lakhs; and 30% for 10+ Lakhs yearly earnings.
Thus, somebody earning Rs 12 Lakhs a year would pay Rs 1,85,000 as tax since his tax in various tax slabs adds up to 0 + 25,000 + 1,00,000 + 60,000 = Rs 1.85 Lakhs.
Sheela marvelled at this simple calculation – so the income tax for the whole year is this easy to calculate! Arun explained that there are some exemptions and additional tax surcharges but this simple calculation is most part of tax calculations.
Arun continued with the FD example, “So Sheela, you see that since I’m in the 30% tax bracket, our entire FD interest will be taxed at 30%. Out of this tax, the bank deducts 10% and the balance 20% has to be paid by me while filing income tax returns.
Thus net returns we will get is 5.6% only. How?
8% interest – [30% of 8% tax, ie, 2.4%] = 5.6%.
How does it compare with 7.5% of inflation that you face when you buy those breakfast cereals and the cream biscuits?”
Sheela asked him, “See Arun. I understand that some taxes have to be paid, but is there a way that we can minimise the same legally?”
Arun explained, “As salaried class, whether serving or getting pension, there’s very little we can do anything about the tax on the salary or pension that I receive since I have just no control on what I get and the tax that Govt levies on it. Hence, there’s no use getting worked up over an issue where we have no control. There is a small amount of tax we can save on our salaries/pensions by way of investment in some specified avenues, home loan etc, but that’s really not very much.
However, there is a lot of tax that we can save by intelligently investing our earnings so that we pay no tax or almost no tax thereafter. Thus, we should actively look for saving the tax through intelligent investing. But, this is something most of the people do not bother about, even though this is very much within their control.
So, in effect, most of us worry our heads off on something over which we have no control (‘saving tax on salary/pension’) and worry nothing over which we have full control (‘tax efficient investments after we have earned our salary/pension’)!”
Sheela concurred that it was indeed a very stupid and illogical idea to worry about saving tax where people could do nothing and not caring about tax where they could actually do everything.
Power of Compounding
“Sheela, do you remember studying about simple and compound interest in your school”, Arun asked. Sheela affirmed and confirmed that she still sort-of remembers those two small formulae of simple and compound interest.
Arun continued, “This is a small learning which we all know but somehow forget when time comes to apply it. We’ve all learned this in our schools. But most of us are unaware of the REAL power of compounding. If I were to tell you that saving just Rs 10,000 for 10 years in an 8% earning tax-free investment like DSOPF or PPF will get you Rs 18 Lakhs”.
Sheela remembered the days when his painstakingly-made small monthly contributions to DSOPF had enabled them to set up their house since Arun had refused to take anything from her parents in marriage.
“If this surprises you Sheela”, Arun continued, “let me give you more surprise: Investing a mere Rs 1000 per month in an equity (stocks or shares related) product for 35 years will accumulate Rs 1.48 Crores for you. But if you invest start just 5 years later, ie invest for 30 years instead of 35 years, your accumulation will be less than half, ie Rs 70.10 Lakhs. If the period is further reduced by 5 years, ie for 25 years, the accumulation will be further halved to Rs 32.84 Lakhs.”
“What’s happening? This is the power of compounding which is helping you accumulate disproportionately since you’ve exhibited the patience and knowledge of continuously compounding your investments year-after-year without succumbing to the lure of taking out money at slight pretext.”
Arun had considered compounded returns of 15% per annum on equity in the example above, which is a reasonable figure for such long term equity investments.
So final Learning!
Arun asked if Sheela found it all interesting. Sheela definitely had and she was also happy that she had learnt all this money related stuff without the jargon that she was fearing all through. Arun concluded the day’s learning with a re-cap of the important stuff.
Inflation is a monster which eats into our money unless we’re conscious about it. We need to ensure that we invest into products that overall give us positive inflation-adjusted returns.
Tax is a bug bear. At some places, it has to be paid and we can’t do anything about it. But we need to invest intelligently so that we don’t pay tax where it can be easily avoided.
Make Power of Compounding your friend. Avoid the urge to take out money from your long term investments like DSOPF, PPF or equity products at the slightest pretext. An acknowledged intelligent guy like Albert Einstein had said, “Compound interest is the Eighth Wonder of the World”.